What’s the Difference Between Roth IRA and After-Tax 401(k) Contributions?
While both Roth IRA and after-tax 401(k) plan allow you to save for retirement using money you’ve already paid tax on, there are some key differences.
Contribution Limits
Designated Roth contributions to a 401(k) or after-tax 401(k) contributions are contributions made from compensation with dollars that have already been taxed. These contributions don’t reduce your income, so you can’t deduct them on your tax return. Putting money into your 401(k) account with after-tax contributions can also help maximize your contributions, lower your tax burden, and streamline your contributions. The aggregate limit for 401(k) pre-tax elective deferrals and designated Roth contributions for 2022 is $20,500 ($22,500 in 2023), plus another $6,500 ($7,500 in 2023) in catch-up contributions if you are 50 or older. Granted, many people aren’t able to max out their pre-tax and designated Roth contributions, and if this describes your situation, this limit may not seem restrictive. However, if you have the financial means and the desire to save more than the limit, you can do so with after-tax contributions if your 401(k) allows them. The combined annual contribution limit for IRAs (both traditional and Roth) is $6,000 in 2022 ($6,500 in 2023). If you’re age 50 or up, you can contribute an additional $1,000 as a catch-up contribution, making your 2022 limit $7,000 ($7,500 in 2023.) That means, you can contribute up to that amount if you meet the income eligibility criteria and do not have any other IRA contributions in the year.
Income Eligibility
After-tax 401(k) plans do not have any income-based restrictions for contributions. Roth IRAs, on the other hand, have income eligibility criteria that determines if you can contribute fully, partially or not at all towards the annual contribution limit. Roth IRAs do not have any required minimum distribution but you may be subject to a 10% early withdrawal penalty if you withdraw your funds before the age of 591/2 years. However, after-tax 401(k) plans require mandatory distributions after age 72 unless you’re still working or are 5% owner in the company.
Eligibility for Rollovers
After-tax contributions also mitigate your tax burden in retirement in another way. At the time you leave your company or retire, you will have the ability to roll the tax-deferred earnings growth into a traditional Individual Retirement Arrangement (IRA) and roll your after-tax 401(k) contributions into a Roth IRA. This means that your earnings can continue to grow on a tax-free basis if you leave the money in the traditional IRA until after reaching age 59 1/2. That’s because the IRS considers the earnings associated with the after-tax contributions as pre-tax amounts.
The Bottom Line
In most cases, your retirement plan investment options for after-tax contributions are identical to those in pre-tax and designated Roth accounts. If your 401(k) plan offers after-tax contributions, consider this option if:
You’re a high earner. While many people aren’t able to max out their pre-tax retirement plan contributions, if you are fortunate enough to earn a salary that causes you to regularly hit the annual contribution limit, you can save more through after-tax contributions to a 401(k) plan or another defined-contribution plan.You want to maintain emergency savings. Since you can withdraw your after-tax contributions tax-free, you can dip into them to cover unplanned expenses.Your income fluctuates. If you work a seasonal job, for example, your income may change each year. In years when you earn a lot of income, you can boost your savings potential through after-tax contributions. When times are lean, you can make pre-tax or designated Roth contributions within the contribution limit.
